In principle, the Output Gap represents the difference between the actual demand for goods and services and the economy’s maximum productive capacity. This capacity, known as Potential GDP (Maximum Concept), is what the GDP would be if all labor and capital were utilized to their absolute fullest.
The Output Gap is supposed to be the most direct indicator of inflationary pressure:
- Positive Output Gap (Excess Demand): Inflationary pressure.
- Negative Output Gap (Excess Supply): Deflationary pressure.
Logically, if inflationary pressure is too high, contractionary policies are appropriate; if it’s too low, expansionary policies are the way to go.
The Shift from “Maximum” to “Average”
Interestingly, the “Maximum Concept” of the Output Gap has fallen out of favor. This is likely because the resulting Potential GDP figures become unrealistically high. It makes sense—in the real world, idle labor and equipment never truly hit zero.
In its place, the “Average Concept” of Potential GDP has become the standard we see today. If you’re looking for a quick estimate, you can calculate this using an HP filter. This model assumes that if labor and capital are operating at their historical average levels, there is neither inflationary nor deflationary pressure.
For most countries where resources are consistently utilized, this might be a meaningful figure. However, for a country like Japan, which has failed to achieve desirable inflation for decades, such a benchmark is practically meaningless. If we are operating at a “historical average,” we are almost certainly still under deflationary pressure.
A Faulty Tool for Japan
My conclusion is that the Output Gap figures currently circulating are a poor fit for Japan. They shouldn’t be used as definitive proof of inflation or deflation. At best, they show the direction of pressure.
That said, it’s a tool worth keeping in your arsenal to counter-attack “fiscal hawks” when they claim, “The negative output gap is gone, so deflationary pressure no longer exists.”
Putting it into Practice: Critiquing the Elites
Let’s look at a recent example from Satoshi Shimazawa (2023), a professor at Kanto Gakuin University and a Tokyo University elite who began his career at the Economic Planning Agency. His core argument, citing IMF data, is that because Japan still runs a massive fiscal deficit even after reaching “Potential GDP,” we need spending cuts or tax hikes—specifically, the equivalent of a 12% increase in the consumption tax.
Setting aside the obvious question of whether tax hikes would just shrink the economy and reduce tax revenue further, we must ask: Does the IMF use the “Maximum” or “Average” concept? According to De Masi (1997), which the IMF World Economic Outlook Database references, potential output is defined as “normal” (not maximum) capacity utilization. This confirms it’s the Average Concept.
In other words, it’s an underestimate. Arguing about fiscal deficits based on such flawed premises is a futile exercise.
Statistics are Not Gospel
Even De Masi (1997) admits that “potential output and the output gap are unobservable variables” and are “difficult to estimate in a completely satisfactory manner.” In short, these aren’t precision statistics. Figures can also swing wildly due to base-year revisions in GDP data.
The Output Gap should be viewed as a mere reference point. It should never be the foundation for a definitive, one-sided argument.
References: Satoshi Shimazawa, “Japan is Not in a State of Fiscal Austerity…” (Sept 25, 2023). Paula R. De Masi, IMF Estimates of Potential Output; Theory and Practices (IMF, Dec 1997).
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